Do low levels of short-term interest encourage risk-taking that can be considered ‘excessive’? Do low interest rates imply higher credit risk in the short-run? In the medium-run? New empirical research suggests that the answers are a resounding ‘yes’, a subtle ‘no’ and a qualifying ‘it depends’.

In the heat of the summer turmoil in the global financial markets, observers immediately argued that the low levels of short-term interest rates during the 2002-2005 period created the conditions for excessive risk-taking and were consequently one of the main causes of these almost unprecedented credit market convulsions.1,2 Despite the theoretical appeal and wide-spread resonance of this contention,3 no detailed empirical evidence — as far as we are aware — has established a clear and direct link from monetary policy onto bank risk-taking.4

To analyse the impact of short-term interest rates on bank risk-taking is not straightforward. Monetary policy is endogenous: when financial stability is jeopardised, for example, monetary authorities may react by lowering interest rates, making any econometric identification extremely difficult. After the collapse of LTCM in 1998, for example, the Federal Reserve reduced the federal funds rate during the ensuing period of high financial uncertainty.

An excellent setting to econometrically identify the impact of short-term interest rates on bank risk-taking is Bolivia. In recent years, the boliviano was pegged to the US dollar and the financial system was highly dollarised. During this period, the proper measure of short-term interest rates in Bolivia was the US federal funds rate, which is exogenous to Bolivian economic conditions. Hence, using the Bolivian credit registry, we analyse on a loan-by-loan basis the impact of the US federal funds on risk-taking and credit risk. The registry contains detailed contract information on all loans issued by any bank operating in the country as well as several measures of bank risk-taking such as ex-post loan performance, internal credit ratings, loan rates, and borrower credit history. The analysis draws from the 1999-2003 period, when the funds rate varied between 0.98% and 6.5%, and the boliviano was pegged to the US dollar.

We find that short-term interest rates affect risk-taking and credit risk. In particular, low interest rates encourage ex-ante risk-taking. Prior to loan origination, low interest rates imply that banks soften their lending standards for new loans – banks give more loans to borrowers with lower credit score and/or with bad credit history. Not only do banks take loans with higher ex-ante risk but also grant new loans that have higher ex-post credit risk, which we measure using a loan’s hazard rate, i.e. the default rate per unit of time. In addition, banks do not seem to price these extra risks they take. This finding suggest that our results are not driven by a higher demand for loans from risky firms (vis-à-vis less risky firms) when interest rates are low.5 All in all, low short-term interest rates seem to increase the banks’ appetite for risk.

We also find that banks which are less-well monitored and disciplined (i.e., subject to more moral hazard) not only take on more risk but they especially take it when interest rates are low. Low rates therefore imply excessive risk-taking. When rates are low not only do these banks take on more risk, but loan spreads are further reduced at these banks despite the higher ex-post realisation of credit risk.

We also analyse in a duration model how the stance and the path of interest rates affect credit risk. We find that the hazard rate increases with lower interest rates at loan origination but also increases as a result of higher rates during the life of the loan. Consequently, there is a completely different impact of lower interest rates on the credit risk of new vis-à-vis outstanding loans. In the short-term, lower interest rates reduce the total amount of credit risk of the banks since the volume of outstanding loans is larger than the volume of new loans. In the medium-term, however, very low interest rates worsen credit risk, especially if interest rates rise at least back to the ‘normal’ levels and the banks’ portfolios are loaded with riskier loans from the era of ‘cheap’ money!

Some policy implications

We find that the level of short-term interest affects bank risk-taking and the ‘amount of credit risk in the system’. Banks remain at the core of the financial system and credit risk is the most important risk banks face. Consequently, the stance and the path of monetary policy significantly affect financial stability. Indeed, very low interest rates for too long make the reversal to higher ‘normal’ rates hazardous. Therefore, prudential supervision cannot act independently of the stance of monetary policy. (In fact, empirical evidence suggests that the two functions may affect and even complement the behaviour of the monetary authority.6) When short-term interest rates are too low and there is excessive liquidity in the financial markets, prudential standards may have to be tightened, through dynamic and forward-looking capital requirements and/or provisioning, for example.

The critical moment for financial instability comes, when short-term interest rates were unusually low for a long time and then return at least, for example, to their ‘normal’ levels. In fact, we find that the lower the interest rates were and the higher they move up afterwards, the worse credit risk will be. During this critical period of transition to higher interest rates, liquidity requirements should increase to offset the higher instability. When interest rates rise, in contrast, we find that bank risk-taking is reduced as lending standards get tougher. Hence, capital requirements should not be tightened then, it’s too late! Regulatory capital should have been higher before this moment of rising interest rates, when the rates were low and risk-taking excessive.

All in all, our findings suggest 1) that prudential supervision cannot act independently of the stance and path of monetary policy, 2) that wide and fast variations from low-to-high interest rates have a negative impact on financial stability, and 3) that ‘cheap’ money is not a free lunch.

Footnotes

1 For details see Ioannidou, V.P., S. Ongena, and J.L. Peydró, (2007) "Monetary Policy and Subprime Lending: "A Tall Tale of Low Federal Funds Rates, Hazardous Loans, and Reduced Loan Spreads", CentER - Tilburg University / European Central Bank, Mimeo. For complementary and supportive evidence using European data for over more than 20 years, see G. Jiménez, S. Ongena, J.-L. Peydró and J. Saurina, (2007) “Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk?”, CEPR DP 6514. Any views expressed are only those of the authors and should not be attributed to the European Central Bank or the Eurosystem.2 See for example “How Credit Got so Easy and Why It Is Tightening”, Front Page, The Wall Street Journal, August 7th, 2007, and the VoxEU.org column by Boeri T. and L. Guiso (2007) “Subprime Crisis: Greenspan’s Legacy”.3 See Matsuyama, K., (2007) "Credit Traps and Credit Cycles," American Economic Review 97; Dell'ariccia, G., and R. Marquez, (2006) "Lending Booms and Lending Standards," Journal of Finance 61; Rajan, R., (2006) "Has Finance Made the World Riskier?," European Financial Management 12; Borio, C., and P. Lowe, (2002) "Asset Prices, Financial and Monetary Stability: Exploring the Nexus," BIS Paper 114.4 In contrast, the effects of monetary policy on the volume of credit have been widely studied and documented: Bernanke, B.S., and A.S. Blinder, (1992) "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review 82; Bernanke, B.S., and M. Gertler, (1995) "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives 9; Kashyap, A.K., and J.C. Stein, (2000) "What Do a Million Banks Have to Say about the Transmission of Monetary Policy," American Economic Review 90.5 In Stiglitz, J., and A. Weiss, (1981) "Credit Rationing in Markets with Imperfect Information," American Economic Review 71, the demand for funds from risky borrowers increases when interest rates are higher. 6 See for example, Peek, J., E. S. Rosengren, and G. M. Tootell, (1999) “Is Bank Supervision Central to Central Banking,” Quarterly Journal of Economics 124 and Ioannidou, V. P., (2005) “Does Monetary Policy Affect the Central Bank's Role in Bank Supervision?,” Journal of Financial Intermediation 14.